Algorithmic trading uses computer programmes applying algorithms, which determine various aspects including price and quantity of orders, and most of the time placing them without human intervention.
15 July 2022
Questions and Answers on MiFID II and MiFIR market structures topics, ESMA70-872942901-38 updated, provides answers to:
The respective legal definition is comprised in Article 4(1)(39) of MiFID II.
Pursuant to this provision algorithmic trading is "trading in financial instruments where a computer algorithm automatically determines individual parameters of orders such as whether to initiate the order, the timing, price or quantity of the order or how to manage the order after its submission, with limited or no human intervention, and does not include any system that is only used for the purpose of routing orders to one or more trading venues or for the processing of orders involving no determination of any trading parameters or for the confirmation of orders or the post-trade processing of executed transactions."
Moreover, Article 18 of the Commission Delegated Regulation (EU) 2017/565 of 25 April 2016 explains the notion of a system with “no or limited human intervention” - it is where, for any order or quote generation process or any process to optimise order-execution, an automated system makes decisions at any of the stages of initiating, generating, routing or executing orders or quotes according to pre-determined parameters.
Algorithmic trading includes arrangements where the system makes decisions, other than only determining the trading venue or venues on which the order should be submitted, at any stage of the trading processes including at the stage of initiating, generating, routing or executing orders (Recital 21 of the said Commission Delegated Regulation 2017/565).
Algorithmic trading means trading in financial instruments where a computer algorithm automatically determines individual parameters of orders such as:
- whether to initiate the order;
- the timing, price or quantity of the order; or
- how to manage the order after its submission;
with limited or no human intervention.
Algorithmic trading does not include any system that is only used for:
- routing orders to one or more trading venues;
- processing of orders involving no determination of any trading parameters;
- confirmation of orders; or
- the post-trade processing of executed transactions.
Financial Conduct Authority, Markets in Financial Instruments Directive II Implementation – Consultation Paper I (CP15/43), December 2015, CP15/43, p. 206-207
Hence, algorithmic trading encompasses not only the automatic generation of orders but also the optimisation of order-execution processes by automated means.
Interestingly, even the use of a relatively simple algorithm qualifies as algorithmic trading in the light of MiFID rules.
According to the ESMA clarification of 19 December 2016 (Questions and Answers on MiFID II and MiFIR market structures topics, ESMA/2016/1583) "the fact that a person or firm undertakes trading activity by means of an algorithm which includes a small number of processes (e.g. makes quotes that replicate the prices made by a trading venue) does not disqualify the firm running such algorithm from being engaged in algorithmic trading."
Conversely, if an investment firm merely transmits a client's order for execution to another investment firm who uses algorithmic trading, the transmitting investment firm is not engaged in algorithmic trading (ESMA has confirmed such an interpretation explicitly in the said Q&As of 19 December 2016: "the transmission of an order for execution to another investment firm without performing any algorithmic trading activity is not algorithmic trading").
A subset of algorithmic trading is High Frequency Trading (HFT).
The term "automated trading" is also sometimes differentiated, it means the use of computer programmes to enter trading orders where the computer algorithm decides on aspects of execution of the order such as the timing, quantity and price of the order.
Legal requirements for algo firms
Investment firms engaging in algorithmic trading and trading venues where such trading takes place are subject to enhanced regulatory scrutiny.
In particular, algo firms must abide by the Commission Delegated Regulation (EU) 2017/589 of 19 July 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards specifying the organisational requirements of investment firms engaged in algorithmic trading (also known as RTS 6).
Regulated markets must have effective systems, procedures and arrangements, including requiring members or participants to carry out appropriate testing of algorithms and providing environments to facilitate such testing, to ensure that algorithmic trading systems cannot create or contribute to disorderly trading conditions on the market and to manage any disorderly trading conditions which arise from such algorithmic trading systems, including systems to limit the ratio of unexecuted orders to transactions that may be entered into the system by a member or participant, to be able to slow down the flow of orders if there is a risk of its system capacity being reached and to limit and enforce the minimum tick size that may be executed on the market (Article 48(6) of MiFID II).
Pursuant to Article 17(1) MiFID II, an investment firm that engages in algorithmic trading must, moreover, have in place:
- effective systems and risk controls suitable to the business it operates to ensure that its trading systems are resilient and have sufficient capacity, are subject to appropriate trading thresholds and limits and prevent the sending of erroneous orders or the systems otherwise functioning in a way that may create orcontribute to a disorderly market;
- effective systems and risk controls to ensure the trading systems cannot be used for any purpose that is contrary to the MAR Regulation or to the rules of a trading venue to which it is connected;
- effective business continuity arrangements to deal with any failure of its trading systems and shall ensure its systems are fully tested and properly monitored to ensure that they meet the requirements laid down above.
Other MiFID II requirements for algo firms cover, in particular:
– there must be a clear and formalised governance framework,
– compliance staff must have at least a general understanding of algorithmic trading and contact with individuals who have access to functionality to cancel all unexecuted orders,
– where there is IT outsourcing, the firm remains fully responsible for its regulatory obligations,
– the firm must have sufficient appropriately trained technical, legal, monitoring, risk and compliance staff,
– the firm must employ an automated surveillance system to detect market manipulation,
– the firm must have pre-trade controls in respect of price, value, trade volumes, message volumes, trader permissions, and, market and credit risk limits,
– there must be real time monitoring of all activity under its trading code for signs of disorderly trading, and, effective post-trade controls,
- systems must be fully tested (including conformance testing with the venue) before deployment and deployed or substantially updated only on the authority of a senior management designate and only where there are predefined trading limits,
- the firm must maintain defined pre-trade controls on order entry, monitor all trading activity under its trading code on a real-time basis, and continuously operate post- trade controls, including of its market and credit risk,
- the firm must have emergency ‘kill functionality’, allowing it to cancel all unexecuted orders with immediate effect (compliance staff must maintain contact with the individual at the firm who is able to cancel immediately any or all of the firm’s unexecuted orders).
The firm engaging in the algorithmic trading must carry out an annual self-assessment and issue a validation report covering:
– its algorithmic systems and strategies,
– the governance and control framework,
– its business continuity arrangements,
– stress testing,
– its overall compliance with the other MiFID II requirements.
Specific requirements apply if an investment firm:
- engages in algorithmic trading to pursue a market making strategy (Article 17(3) and (4) of MiFID II),
- provides direct electronic access to a trading venue (Article 17(5) of MiFID II).
In the update of 15 July 2022 of the document Questions and Answers on MiFID II and MiFIR market structures topics (ESMA70-872942901-38 Question 34) ESMA provided its opinion how firms should ensure compliance with the requirements in Article 17 of MiFID II and RTS 6 when using third party systems which offer algorithmic trading functionalities.
According to the ESMA When firms use third party systems offering algorithmic trading functionalities, they are ultimately responsible for compliance with the relevant requirements in Article 17 of MiFID II and RTS 6, as specifically detailed in Article 4 or RTS 6. However, lacking direct control over the system, its operation and the algorithms deployed, these firms might not be materially able to ensure that all requirements are met.
In such instances, firms can ensure compliance with those technical requirements that cannot be otherwise met by the firm itself through contractual arrangements with the system provider, where the latter commits to ensure that the system, its operation and the algorithms deployed are compliant with the relevant legal requirements.
The MiFID II requirements for pre trade risk controls are set out in detail within Article 15 of RTS 6, which requires algo firms to maintain:
- market and credit risk limits,
- maximum order volumes and maximum order values,
- maximum message limits,
- repeated automated execution throttles (to pause application of the strategy until restarted by human intervention),
- price collars.
However, as observed by the UK FCA in the document of February 2018 “Consultation Paper, Algorithmic trading” (CP5/18)), the level of sophistication within the pre-trade controls used by investment firms exhibits significant differences.
The said FCA’s document contains in this regard the following overview (p. 17):
|Basic controls||Enhanced controls|
|Market and credit limits||Overall credit/market risk limits set across all trading activity, applicable throughout the trading day||Market/credit risk limits split across the firms trading activity within a set time period (e.g. 15 min window) or exposures per symbol|
|Order volume/value||Volume and value limits for orders set per client/trading strategy which applied to all trading activity||
Volume and value limits, set dynamically in relation to the average daily volume (ADV) and touch size for the relevant symbol
|Message limits||A basic limit on the number of orders or messages across all trading activity during the trading day||Message limits broken down into smaller time periods (e.g. 15 min) and/or per symbol|
|Repeated automation throttles||A check on repeated orders across all activity during the trading day||A check on repeated orders and the number of rejected orders across all activity during the trading day|
|Price collars||Price controls which apply a basic check on limit orders vs the current market price||Price collars which differentiated between passive/aggressive orders and/or calculate the anticipated market impact of the order|
Algo firms must maintain post-trade risk controls to monitor their trading activity and take appropriate action where controls are triggered.
Article 17 of RTS 6 requires firms to:
- conduct a continuous assessment and monitoring of market and credit risk exposures (these must be capable of being calculated real-time),
- adopt controls over maximum longs and shorts (and overall strategy positions) for derivatives, specific to the instrument,
- maintain complete, accurate and consistent trade and account information,
- maintain electronic trading logs, reconciled with relevant third parties such as trading venues, brokers, DEA providers,
- ensure traders and the risk function undertakes post-trade monitoring.
Procedures for identification of algorithmic trading
As was said above, even the trading with the use of an algorithm including a small number of relatively simple processes can trigger legal requirements involved with MiFID II algorithmic trading regime.
Firms, therefore, need to develop processes to identify algorithmic trading across the business, they must also to establish processes to capture all new algorithms, trading systems and strategies on an ongoing basis, as well as any material or substantial changes to existing ones (which was underlined by the UK FCA in the document of February 2018 “Consultation Paper, Algorithmic trading” (CP5/18)).
It is important for firms to have the correct tools in place, supported by appropriate staff training, to identify all such activity.
As the FCA in the above document acknowledges, the exact definition and scope of algorithmic trading can vary depending on the type of firm and strategies deployed.
Nevertheless, in general terms, the algorithmic trading strategies can be defined as:
1. investment decision algorithms (determining which financial instruments should be purchased or sold), or
2. execution algorithms (optimising order execution processes with the automated submission of orders and quotes to one or more trading venues),
3. single algorithmic trading strategy combining both of the above elements.
According to the FCA’s aforementioned document of February 2018, investment decision algorithms that do not initiate orders or the timing, price or quantity of an order may not fall under the definition in MIFID II but there is a good practice to ensure these were subject to the same systems and controls as for algorithmic trading.
It is useful to note in this context the difference between Smart Order Routers (SORs) and Automated Order Routers (AOR)
Smart Order Routers (SORs) use algorithms for optimisation of order execution processes that determine parameters of the order other than the venue or venues where the order should be submitted. SORs are undoubtedly qualified as algorithmic trading.
In turn, algorithmic trading does not encompass Automated Order Routers (AOR) where, although using algorithms, such devices only determine the trading venue or venues.
The inherent condition for AOR is that the order is submitted without changing any other parameter of the order (including modifying the size of the order by "slicing" it into "child" orders).
In case the same unmodified order is sent to several trading venues to ensure execution and it is executed in one of these venues, the functionality can also cancel the unexecuted orders in the other venues without qualifying as algorithmic trading.
In the update of 15 July 2022 of the document Questions and Answers on MiFID II and MiFIR market structures topics (ESMA70-872942901-38, Question 33) ESMA explained that orders that are executed through functionalities which additionally to routing orders to trading venues offer automated managing of the order (e.g. automatically redirecting unexecuted portions of such orders to other venues or slicing orders prior to execution) are in the scope of the MiFID II definition of algorithmic trading.
Such functionalities differ from automated order routing systems, as the latter merely determine the trading venue (or trading venues) to which the order has to be sent without changing any parameter of the order (i.e. the order is unmodified in its components, including its size).
On the contrary, algorithmic trading encompasses both the automatic generation of orders and the optimisation of order-execution processes (e.g. slicing of orders) by automated means. Orders executed through such processes should therefore be flagged as algorithmic trading in line with the requirements under Articles 25(2) and 26(3) of MiFIR and Article 8 of RTS 22 and the further specification in Articles 2(c) of CDR 2017/580.
Firms trading through these functionalities should also be considered as engaged in algorithmic trading and apply, the relevant requirements of Article 17 of MiFID II and RTS 6.
Regulated markets must identify, by means of flagging from members or participants, orders generated by algorithmic trading, the different algorithms used for the creation of orders and the relevant persons initiating those orders.
That information is available to competent authorities upon request (Article 48(8) of MiFID II).
An investment firm that engages in algorithmic trading in a EU Member State must notify this to the competent authorities of its home Member State and of the trading venue at which the investment firm engages in algorithmic trading as a member or participant of the trading venue.
The competent authority of the home Member State of the investment firm may require the investment firm to provide, on a regular or ad-hoc basis, a description of the nature of its algorithmic trading strategies, details of the trading parameters or limits to which the system is subject, the key compliance and risk controls that it has in place to ensure the conditions laid down above are satisfied and details of the testing of its systems.
The competent authority of the home Member State of the investment firm may, at any time, request further information from an investment firm about its algorithmic trading and the systems used for that trading.
The aforementioned information is communicated by the competent authority of the home EU Member State of the investment firm on the request of a competent authority of a trading venue at which the investment firm as a member or participant of the trading venue is engaged in algorithmic trading.
The investment firm must keep appropriate records and ensure that those records are sufficient to enable its competent authority to monitor compliance with the respective requirements.